Every investor has a preferred asset class. Some like stocks, some like bonds, others like precious metals, cryptocurrency, or commodities. No matter the investment type, they all have the same objective, to build wealth.
While each asset class has its relative merits, we firmly believe – and have built a company around – the idea that commercial real estate is the premier investment class for building wealth.
In this article, we’ll explain the reasons commercial real estate is a superior investment, ways to invest in CRE, including passive investment, and three elements of a successful private CRE investment.
Why Commercial Real Estate is Superior
For investors looking to grow and preserve wealth over the long term, we feel that there is a strong argument for the inclusion of commercial real estate as part of a broadly diversified investment portfolio for the following reasons:
Cash Flow
The economics of a commercial property are such that the tenant pays rent, which is used to pay the mortgage, and any money left over can be distributed to property owners. We feel strongly that a property must produce cash flow, otherwise owning it is speculating on price appreciation. While there isn’t anything wrong with this strategy, it isn’t the right one for us.
Increasing Cash Flow
Tenant rents aren’t fixed. They tend to rise over time and cash available for distribution rises with them. Rents can rise from contractually mandated increases, operating efficiencies, or from repositioning a property. Either way, the result is the same: increasing cash flow.
Principal Appreciation
Commercial real estate is valued on a metric called Net Operating Income, which is income less operating expenses. As Net Operating Income increases, so does property value.
Low Correlation with Traditional Equity and Bond Markets
Prices for commercial real estate tend to be less volatile than traditional equity and bond markets and loosely correlated. When the equity markets are down, commercial real estate prices may hold steady or even rise.
Tax Benefits
Commercial real estate ownership comes with two significant tax advantages:
- Property value can be written down through a process called depreciation and the losses can offset taxable income.
- In addition, taxes on a profitable sale can be deferred by reinvesting them in another property of “like kind” in a process known as a 1031 Exchange.
Inflation Hedge
Over time, prices for goods and services tend to rise. If the value of an investment isn’t rising as fast as, or faster, than inflation it may actually be losing value in “real” terms. Because rising rents drive rising property values, commercial real estate tends to be a good hedge against inflation.
For those interested in making a commercial real estate investment, there are several ways to do so.
Ways to Invest in Commercial Real Estate
Commercial real estate investors tend to fall into one of two categories, direct or passive.
Direct Ownership
Direct ownership is the most traditional way to invest in commercial real estate. With this method, one or more partners are responsible for finding the property, investing their own capital, arranging their own debt, and managing the asset once purchased. The upside is that the owner has more say in the day to day management of the property and gets to reap all of the financial benefits. But, the downside is that managing a commercial real estate asset requires specialized expertise and dedicated focus. In addition, it can be tough to compete with institutional buyers and hard for an individual to diversify their portfolio as it’s likely that they used most or all of their capital to get into one deal.
Passive Real Estate Investing
A passive real estate investment is all about leverage. An individual with capital to invest can leverage the systems, processes, and relationships of an experienced real estate sponsor to acquire a smaller portion of a larger commercial quality asset. Doing so allows them to diversify their portfolio through investments with multiple sponsors or multiple investments with the same sponsor. It also allows the investor to focus on what they are best at (medicine, finance, accounting, etc) and leaves the sponsor to focus on what they are best at, running real estate.
Three Ways to Passively Invest in Commercial Real Estate
For investors looking for a passive commercial real estate investment, there are three ways to do it:
1. Public REITs
Publicly traded REITs are companies that invest in specific real estate sectors like industrial, hotels, and multifamily. Because they are publicly traded, they can be bought and sold like a stock and the investor gets a current portfolio, knows the sponsor strategy, and receives a portion of a broadly diversified investment portfolio.
The downside of a publicly-traded REIT is they have historically underperformed private CRE as an asset class and the investor doesn’t get the tax benefit of depreciation.
2. Private Equity Funds
In a private equity fund, an investor gives a manager a certain amount of money to be deployed in a “blind pool” of assets as the manager sees fit. The major benefit of a private equity fund is that the investment is illiquid so the price is not as volatile and the investment is broadly diversified across multiple assets in the “blind pool.”
The downside to a private equity fund is that the investor is betting more on the sponsor’s track record than any single asset. Plus, they don’t really know what they are investing in because it may not be decided at the time of investment.
3. Direct Private Deals
In a direct private deal, an investor places their capital with a sponsor to invest in a single, known, asset. The primary benefit of a direct private deal is that the investor will be able to read about the property, its location, research the financial statements, and understand the business plan prior to making an investment. In addition, they can diversify their portfolio through multiple assets and get the benefit of relative price stability.
But, private direct deals aren’t available to everyone. They can only be accessed by accredited investors, meaning individuals with a million dollars in assets or at least $200,000 in income for each of the past three years.
We sponsor private direct deals and, through years of experience and dozens of deals, we’ve refined our strategy to identify three elements of a successful investment.
Three Elements of a Successful Private CRE Investment
Investors considering a private, direct commercial real estate investment should look for three things:
1. The Right Deal
A private investor should look for the right deal, in the right market, with the right risk profile and the right price. “Right” may have a different definition for every individual so it should be consistent with their risk tolerance and investment time horizon.
2. The Right Structure
The financial incentives of the deal should be structured to align the interests of both the investor and the sponsor. Often this means that the investor gets a “preferred return” before the sponsor is eligible to receive a share of the property’s cash flow.
3. The Right Sponsor
Working with the right sponsor is paramount to success. Investors should look for a proven track record, adequate financial and management resources, and strong relationships with brokers, tenants, and lenders.
On behalf of our investors, we invest a significant amount of time and effort in our underwriting process to ensure that these elements are present in each investment we make.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
